Finance and Economics Discussion Series Divisions of Research & Statistics and Monetary Affairs Federal Reserve Board, Washington, D.C. Information in Yield Spread Trades Yang-Ho Park 2019-025 Please cite this paper as: Park, Yang-Ho (2019). \Information in Yield Spread Trades," Finance and Economics Discussion Series 2019-025. Washington: Board of Governors of the Federal Reserve System, https://doi.org/10.17016/FEDS.2019.025. NOTE: Staff working papers in the Finance and Economics Discussion Series (FEDS) are preliminary materials circulated to stimulate discussion and critical comment. The analysis and conclusions set forth are those of the authors and do not indicate concurrence by other members of the research staff or the Board of Governors. References in publications to the Finance and Economics Discussion Series (other than acknowledgement) should be cleared with the author(s) to protect the tentative character of these papers. Information in Yield Spread Trades Yang-Ho Park Federal Reserve Board March 26, 2019 ABSTRACT Using positions data on bond futures, I document that speculators’ spread trades contain private information about future economic activities and asset prices. Strong steepening trades are associated with negative payroll surprises in subsequent months and can predict asset markets’ reaction to future payroll releases, suggesting that spec- ulators hold superior information about future payrolls. Steepening trades can also predict the rise of stock prices within a few hours before subsequent FOMC announce- ments, implying that the pre-FOMC stock drift is driven by informed speculation. Overall, evidence highlights spread traders’ superior information and its important role in explaining announcement returns and pre-announcement drifts. JEL Classification: E32; E43; G12; G14 Keywords: informed trading; term structure; business cycle; pre-FOMC; macroeconomic announcements I am grateful for comments and suggestions from Hie Joo Ahn, Marcelo Ochoa, Clara Vega, Min Wei, and seminar participants at the 2018 Predicting Asset Returns Workshop at Orebro¨ University and the Second Conference on Forecasting at Central Banks. This paper also benefited from the excellent research assistance of Sathya Ramesh and Robertson Wang. Disclaimer: The analysis and conclusions set forth are those of the author and do not indicate concurrence by the Board of Governors of the Federal Reserve System or other members of its research staff. Send correspondence to Yang-Ho Park, Risk Analysis Section, Board of Governors of the Federal Reserve System, 20th & C Streets, NW, Washington, D.C., 20551, Tel: (202) 452-3177, e-mail: [email protected]. Do sophisticated investors have superior information acquisition and processing ability? How does private information, if any, get incorporated into asset prices? These long-lasting questions in finance have received more attention as investors have increasingly relied on data-crunching technologies and alternative data sources, such as satellite images, traffic data, shipping data, mobile devices data, internet search data, social media data, and credit card transactions. Alternative data are used to analyze not only firm-specific information but also macroeconomic activities. For example, Henderson, Storeygard, and Weil (2012) show that satellite images on night lights can be useful for measuring economic growth when traditional data are of low quality or unavailable. Orbital Insight, a big-data firm in Palo Alto, claims that it has predicted retail sales better than Bloomberg consensus forecasts.1 This paper studies the macroeconomic information contained in investors’ yield spread trading—a purchase of one bond and a simultaneous sale of another bond with a different maturity. The idea is motivated by the well-established macroeconomic fact that the slope of the yield curve has a close relationship to economic activity and monetary policy.2 Curve-steepening trades can be useful right before or duringa recession in which short-term rates tend to drop faster than long-term rates. Curve- flattening trades can be useful at the peak of the business cycle or during a monetary tightening in which short-term rates tend to rise faster than long-term rates. From an informed trading perspective, spread trading has two appealing features compared to outright trading: low cost and low risk. Spread trading requires a smaller margin than outright trading, facilitating informed traders to take higher leverage. Black (1975) and Easley, O’Hara, and Srinivas (1998) show that leverage is a crucial determinant of informed trading. Moreover, spread trading is viewed as a low-risk strategy because it is largely shielded from a parallel shift in the term structure of interest rates. Duration-matched spread trading, in particular, can be useful when investors are informed about economic activity but uncertain about more permanent shocks, such as inflation shock, which tend to affect yields more evenly across all maturities. A casual observation suggests that speculators in bond futures may have some 1 See the article at https://orbitalinsight.com/orbital-insight-correctly-predicts- retail-sales-miss-hit-rate-grows-78. 2 See Diebold, Rudebusch, and Aruoba (2006), G¨urkaynak, Sack, and Swanson (2005), and Rudebusch and Wu (2008). 2 information associated with the slope of the yield curve. Figure 1 shows the excess net number of speculators in bond futures using the Commitments-of-Traders (COT) report published by the Commodity Futures Trading Commission. With the average net number of speculators removed, the excess net number is intended to measure abnormal trading activity in short-term bond markets relative to long-term ones. The figure shows remarkable divergences in abnormal trading activity between Eurodollar futures and 30-year Treasury futures during all of the recession periods. In particular, speculators took a bullish (bearish) view on short-term (long-term) bond markets relative to long-term (short-term) bond markets during all of the recession periods. Such empirical regularity hints at the possibility that speculators (but not hedgers and small retail investors) have been good at timing the slope of the yield curve along business cycle fluctuations. By introducing some indicators mimicking speculators’ spread trading, I find that the indicators have predictive power for future economic activity. Probit regression analysis shows that speculators’ stronger steepening (flattening) is associated with a higher (lower) probability of subsequent recessions. In addition, stronger steepening (flattening) is associated with lower (higher) non-farm payroll growth rates in subse- quent months. The predictive power of the spreading indicators cannot be spanned by other business-cycle indicators such as term spreads and bond excess premiums as introduced by Gilchrist and Zakrajˇsek (2012). To understand the source of the predictive power of spreading indicators, I com- pare speculators’ ability to forecast future payrolls to that of professional forecasters.3 I find that strong steepening (flattening) is associated with negative (positive) payroll surprises in subsequent months, suggesting that spread traders hold some informa- tion that is not accounted for by professional forecasters. Furthermore, spreading indicators can forecast financial markets’ response to future payroll announcements. Specifically, strong steepening is followed by positive returns on short-term bonds and depreciations of the U.S. dollar against the British pound and Swiss franc at the times of future payroll releases. Overall, I argue that speculators have a superior ability to analyze future payrolls and that such information manifests itself into their betting on the slope of the yield curve. 3 Among various macroeconomic announcements, payrolls are known as “the king of announce- ments” (see Andersen and Bollerslev 1998). 3 I also show that the information in spread trades can explain the otherwise puz- zling pre-Federal Open Market Committee (FOMC) stock drift, the fact that a large fraction of excess stock returns have materialized during a few trading hours im- mediately preceding scheduled FOMC announcements (see Lucca and Moench 2015). Specifically, I find that speculators’ stronger steepening is followed by larger increases in stock prices during same-day trading hours before subsequent FOMC announce- ments. After the information in steepening trades is accounted for, the pre-FOMC same-day stock drift is no longer statistically significant. An active pre-FOMC timing strategy conditioned on the information in steepening trades would have delivered a Sharpe ratio gain of 0.34 relative to a naive pre-FOMC buy-and-sell strategy. Over- all, information held by speculators has been incorporated into stock prices through pre-FOMC same-day trading. Why is it that steepening trades are positively (but not negatively) associated with future stock returns? The positive relationship is at first surprising because steepening trades are related to low levels of future economic activities, which may signal low corporate earnings in the future. However, stock markets sometimes inter- pret economic news upside down if the news is expected to affect the future course of monetary policy. In light of the positive relationship, speculators with bad eco- nomic news appear to have anticipated an easing policy and have engaged in informed trading during a few hours before the FOMC announcements. This interpretation is broadly consistent with empirical research showing that